This post was originally titled: “The Average Person Doesn’t Know Much About Personal Investing” but I thought a more positive spin was needed.
I was sitting at the pool during my kids’ swim team practice the other night, and overhead one overweight regular dude talk to another of the same ilk about some investment transaction. One must have been in the financial industry and was referring to helping out the other guy by putting him in touch with his broker, perhaps one he works with. Now these guys probably have a better handle on personal finance than the many of us, but I wonder how much they leave on the table due to expenses and fees versus the gains they are getting.
Appreciating the fact that many individuals, including some of my friends, make their living selling financial products and helping to manage people’s money, I think many of us are better off learning a few basic personal investing credos and sticking with them for the long term. I am an admitted Boglehead subscriber (after Vanguard and Index fund founder John Bogle), and if you want to learn many more of the why’s and how’s, I highly recommend any of the Boglehead Books, but especially: The Bogleheads’ Guide to Investing and The Bogleheads’ Guide to Retirement Planning.
Before you start, I’m going to assume that you’re not drowning in debt and at have at least a small amount of income (or can make some with additional frugality) that you can use for retirement investing. If not, I recommend tracking down some Dave Ramsey books or audiobooks from the library to get a handle on the basics of a small emergency fund and eliminating high interest debt especially. Only after many other conditions are met should you think about taxable investing, but saving for retirement needs to be the priority for most of us. And most of us aren’t saving enough, this USA today article notes that 56% of current workers have less than $25,000 saved. That is just insane, and also illustrates the fact that many are forced to continue working past age 65 just to make ends meet and hoping Social inSecurity lasts for them. It doesn’t have to be like that for you.
Without further ado, here are five of my infallible laws of investing – while it’s written for retirement primarily, they apply to taxable investing as well (though taxable investing has a few other issues to consider not covered here).
1) Start as early as you can (Now, if you haven’t)
Do not underestimate the power of compounding. Any positive return on an investment that is reinvested, adds additional principal that can be further compounded. The longer the time frame of the compounding, the more money you make, so getting started early is critical. I’ll use the rule of 69 (or 72) to illustrate my point. Take your assumed return rate (say 6%) and divide 69 by your percentage rate (6) and that is how many years it takes to double your initial investment (in this case, 11.5 years). So you put $5,000 into an investment and 11.5 years it is now $10,000. Another 11.5 years it is $20,000 and another 11.5 years it is $40,000. So if you started this at 30, by the time you retire at 65 you’ll have $40k on the initial $5,000 investment. But if you didn’t start until 45, you’d have half of that ($20k) at age 68. Time is your friend if you are young, but your enemy if you procrastinate like my parents did (who didn’t really start retirement savings until they were about 50 years old).
2) Use Tax-Advantaged Retirement Accounts First
If you are lucky enough to have an employer sponsored 401(k) or 403(b) that actually matches your income to a certain percent, you need to contribute at least up to that amount. It is basically free money, and even if you have some other debt you are trying to clear, turning down free money (used for your own savings and long-term future) is just dumb. If you don’t have access to one of these plans, open up an Independent Retirement Account (IRA), and really the only one that makes sense is a Roth IRA. All of these accounts allow your money to grow tax-advantaged, meaning the transactions that occur by your funds aren’t taxed on things like capital gains and other fees that erode your returns. Instead, your account grows tax free. Depending on the type (Roth or Traditional IRA or 401k), you are either taxed when you take money out upon retirement (traditional IRA or 401k), or taxed prior to putting the money into the account (Roth), which means you aren’t taxed on the back end at retirement. Either one has their advantages, and many, including me, hedge their bets on tax code and income limits by contributing to both if they have access to both.
Opening up a Roth IRA is also super easy. I recommend Vanguard funds, and you can open up an IRA with a quick call and some e-paperwork directly through Vanguard. The only issue for some is a minimum investment of $1,000. They have great advantages such as automatic savings and reinvestment (you can set up your bank to push money into your account automatically – fees for reinvesting into specific funds are waived if amount pushed through each time is $50 I believe), and among the lowest fees in the industry. If you don’t have $1,000 to start, you can open up an account at a brokerage like Scottrade ($500 minimum), TD Ameritrade (no minimum investment) or E-Trade (no minimum investment). All these accounts allow for automatic savings, but may have some additional transaction fees compared to Vanguard.
Even if you can’t save much in your retirement accounts, a) save at least up to your company match and if that doesn’t apply b) save anything, even $25 a paycheck (automatically pushed to the IRA account) to start the snowball rolling.
Fees come in many forms. There are expense fees, load fees and hidden fees. All the fancy managed funds that you read about in magazines, see advertised on television and get pushed by your investment “friends” all have fees that support their existence and those of the advisers, consultants, statistical team, marketing staff and other hangers-on to the fund. All of these erode your return, which means you have to have returns above the fees to make money. Many actively managed funds have both loads (percent of the purchase value they charge just to by the fund) and higher expense fees. Many are 2-3%, which means your fund needs to consistently perform above the “market” to do as well as “the market” (see index funds below). Eroding your returns by 2-3% is huge, take for example an 8% return versus an eroded return of 5.5% (2.5% less) return off an investment of $10,000 over 30 years. The 8% return over that duration yields approximately $109,400, and the 5.5% return yields only $51,900, less than half! When considering funds and asset allocation, usually lower fees are going to be better. Specific individual active mutual funds may have outstanding short-term returns, but they often return to the mean (come back to the pack) or do worse for a number of reasons, including changing fund managers (most are only in the position for only five years or so) or just not being able to sustain finding the small market inefficiencies that make them so profitable in the short term.
Even index funds have fees, but whether you choose to invest in managed or index funds, keeping an eye on which ones are the lowest may help guide you to make better decisions and ultimately yield you better long-term returns.
4) Index Funds are your best choice
While 401k or 403b plans are often limited in choices and inherently have well hidden administrative fees, you hopefully still have access to some index funds. An index fund doesn’t have an active fund team that strategically researches the market and executes their plan, they simply hold all the funds in a similar distribution as a set index, such as the S&P 500 or the Wilshire 5000. Because they don’t need all those advisers and consultants or marketers, they’re expense ration is very low, and you can usually find them as no-load funds. They also diversify your investment and reduce the risk by holding a large fund portfolio versus individual stock selection. Keep in mind that while there may be all sorts of index funds (small cap, mid cap, value, growth, international), 80% of the overall value of the U.S. stock market is held in the S&P 500, so you have a very large diversification with that single index fund alone.
If your 401k or 403b has funds with high fees and no real index funds, you should at least contribute up to your match, and then, more than likely, take advantage of the low-fee index funds within an IRA that you set up with an outside firm like Vanguard or Ameritrade. Just remember, that like your 401k fund that automatically deposits money from your paycheck, you can automate your IRA or use your bank to do the same with other accounts. Get in the habit of hidden savings so you don’t even miss the money.
5) Asset Allocation
How you distribute your funds in your 401k is also important. Depending on your risk tolerance and your age, this will be key to growing wealth while minimizing the downside, especially if you are close to retirement. If you don’t have financial savvy or the time to really learn this, you can usually find Target Date funds that allocate according to an age formula that changes over time. However, this may be too aggressive for some (many are close to 90% equities until over 50), but still have U.S., International and bond diversification at pretty low expenses.
The John Bogle rule of thumb is own your age (as a percentage of your total portfolio) in bonds, which is considered fairly conservative. A slightly more aggressive rule of thumb is own your age minus ten in bonds, but for some that may even be too conservative. Another Bogle “rule” is to have only 20% of your equity portfolio in International funds. He has many reasons for this, but one of them is that the U.S. stock market already has about 25% of it’s value tied to international business dealings.
So an example portfolio for someone who is 40 years old may be: 30% Bond Market Index Fund (age minus 10), 14% International (20% of 70% equity mix) and 56% Domestic U.S. Mutual Fund Equities. Following a lazy portfolio, you can set this up with three low expense mutual funds (though keep in mind, Vanguard and others may have a minimum investment for each fund, in Vanguard’s case $3,000. Due to this, a Target fund that has a similar approach may be a better option starting out). The total weighted expense ratio for this using Vanguard total stock market Index (VTSMX), total international stock index (VGTSX) and total bond market index (VBMFX) is 0.186 which is outstanding.
Keep in mind, your allocation may vary. If you had money invested in the last crash (2008) and you freaked out, that’s a good indication you have less risk tolerance than those who simply rode it out. My own portfolio is roughly weighted in age minus 10 in bonds, weighted a little higher in riskier international markets as a percentage of equities, with a touch of real estate (REIT) in the mix for further diversification. Otherwise, I follow the index fund approach myself.
So there you have it on a most basic level. A few other bullets to add:
- Don’t try to time the market (trying to get out if you “think” it’s about to crash or buy in at the lowest point) – inevitably you sell too late and buy too early with lower returns than if you had just ridden out the ups/downs
- Don’t chase returns – you are buying at the high point, sometimes in a bubble, which means you would then sell at a low(er) point
- Buy and Hold – follow your asset allocation strategy, rebalance to keep the percentages in line with your risk, and don’t pay attention to the short term market swings. You are in it for the long haul and slow and steady wins the race on investing, not being a gambler trying to get rich quick
- If you have an old 401k from an old job, for the same reason they are limiting at an existing job, you are probably better off rolling it over into a Traditional IRA. Again, you’ll have to set it up at Vanguard or Scottrade or wherever, then fill out a little paperwork with your old 401k plan administrator (MAKE SURE YOU REQUEST A “DIRECT ROLLOVER” to ensure you aren’t paying penalties/taxes) and dump it into the new IRA. You’ll then have to distribute/buy funds in the account according to your asset allocation strategy. The new IRA administrator or e-firm can help walk you through this process.
Empower yourself and maximize how much money you can make. You don’t need to give someone else the money and power to do something that you can do yourself and very likely yield better ultimate returns.
Good luck out there.